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Keeping it in the Family: Inheritance Tax Reform and the Challenge of Wealth Redistribution

July 7, 2021, 7:00 AM

The only two things in life that are certain are “death and taxes.” If this adage is correct, then presumably inheritance tax is the most certain thing of all?

The evidence might seem to suggest so. Taxing the estates of recently deceased individuals may be one of the most unpopular forms of taxation, yet this has not prevented its longevity. In the U.K. for example, the modern system of inheritance tax—levied on the value of the individual’s estate upon death—was introduced in 1894 to help pay off a 4-million-pound ($5.5 million) government deficit. The times may have changed, and the size of government deficits certainly has changed, but the perception that we require death duties in order to balance the country’s books has not.

On the contrary, in the current circumstances we find ourselves in, some have suggested that now is the time for inheritance taxes (along with other capital taxes) to be put to more ambitious use—not only in terms of generating revenue for public spending, but also in encouraging a more equitable society.

Such a suggestion was recently made by the Organization for Economic Co-operation and Development (OECD) in its report on inheritance taxation. The report analyzed the distribution of household wealth and inheritances across the OECD member states, and found they are in general characterized by high wealth inequality and unevenly distributed wealth transfers, which are expected to increase in number and value over the coming years. Without remedial action, the report warns that these unequal wealth transfers have the potential to reinforce unequal concentrations of wealth and opportunities.

OECD Report Findings

Setting aside these general conclusions for a moment, there are a number of more specific findings in the report that would benefit from closer examination:

  • Inheritance taxes have generally been found to generate lower efficiency/administrative costs than other taxes on wealth. This is largely based on the fact that inheritance tax, generally speaking, is collected only once in a person’s lifetime, as opposed to annually like other taxes on net wealth, on gains and income. However, while the picture across the OECD may be different, many families in the U.K. who have experience with the inheritance tax system may disagree with this conclusion—in view of all its exemptions, reliefs, and other complexities. The report also cites recent progress on international tax transparency, such as the Automatic Exchange of Information, which has increased the efficiency with which countries can combat tax evasion.
  • Low tax revenues are partly due to narrow tax bases. Among the 24 OECD members, inheritance, estate, and gift taxes account for a very small proportion—just over 0.5%—of overall tax revenue. This is put down to the narrowness of the tax bases. The most extreme example among OECD members is the U.S., where only 0.2% of estates are subject to inheritance taxes; however, the U.K. is only at 4%, Italy at 6.4%, and Germany at 10%. The report finds that this narrowness is a result of the number of exemptions available, particularly for transfers to close relatives such as a spouse or children.
  • The design of inheritance, estate and gift taxes reduces the effective tax rates, in some cases more so for the largest estates. The most striking example of this is the U.K., where someone with an estate valued over 10 million pounds has a substantially lower effective inheritance tax rate than someone with an estate worth between 1–2 million pounds. In fact, the data suggests the effective rate paid by >10 million-pound estates is less than half that paid by estates valued between 5–7 million pounds. The situation is similar, although less marked, in the U.S., where estates valued between $20–50 million pay an effective rate of 13.62%, compared to 12.72% paid by estates valued over $50 million. This trend is accounted for in the report by the fact that the largest estates comprise more assets benefiting from tax relief, such as business assets or land.

OECD Report Recommendations

Based on the OECD’s findings, their report then offers a series of recommendations for reforming inheritance, estate, and gift taxes, so that they a) generate a higher tax yield, b) better address wealth inequalities, and c) function more efficiently. These recommendations include:

  • Inheritance tax should be levied on the beneficiary of the wealth rather than the donor.
  • It should apply to all gifts and bequests received over the individual’s lifetime (excluding a tax-free lifetime allowance).
  • Exemptions and reliefs should be scaled back for certain assets such as private pensions savings and life insurance pay-outs.
  • Taxing rights in respect of cross-border inheritances should be better aligned with other jurisdictions, and double taxation relief should also be provided.
  • Assets should not be “stepped-up” to fair market value at the time of the bequest, meaning the beneficiary is potentially liable for any capital gains accrued should they choose to sell.
  • Allow for short- and long-term tax payment extensions where certain conditions are met, to help taxpayers avoid liquidity issues.
  • Reporting requirements should be strengthened and tax administrations encouraged to collect more data; also make greater use of data from third parties, i.e. banks.

Inheritance Tax and High Net Worth Individuals

To properly assess the design and functioning of the inheritance tax system, and to make meaningful proposals for its application in social causes like the struggle against inequality, we must first examine the affairs of high net worth individuals (HNWIs).

The findings of the OECD report demonstrate that HNWIs and ultra-HNWIs (UHNWIs) are a key constituent of the inheritance tax base. The exemptions and reliefs available in most jurisdictions mean that the majority of less-wealthy households will not qualify—and the OECD’s recommendations do not seek to change this. For this reason, a well-functioning inheritance tax system is one which accommodates the often-complex affairs of HNWIs and can adapt to particular circumstances.

Samsung Case

To illustrate the role that U/HNWIs play in generating inheritance tax revenue, let us take a high-profile example. In April 2021, the family of the late owner of the Samsung technology empire, Lee Kun-hee, announced they were to hand over $11 billion in one of the largest-ever inheritance tax bills. The late businessman’s estate was large, complex, and contained many assets that are generally eligible for reliefs and exemptions, including shares in Samsung Electronics as well as smaller companies such as Samsung Life Insurance and Samsung C&T.

The family announced their $11 billion bill would be paid in installments (six over five years)—a facility recommended by the OECD and not currently available in the U.K. or U.S.; however, very useful for HNWIs whose liquidity relies on dividends from shareholdings.

Furthermore, alongside the inheritance tax payment, the family pledged billions of dollars in philanthropic donations to healthcare and the arts, including the donation of Lee’s collection of 23,000 artworks and antiques to museums in South Korea. The media reports suggest this philanthropic activity will reduce the family’s inheritance tax liability, demonstrating that exemptions for charitable giving can have the desired effect, and give families some additional freedom to re-purpose certain assets in accordance with the deceased’s interests or wishes.

The arrangement that the Lee family have come to with the South Korean revenue service appears to be effective in another important respect: it safeguards a nationally significant corporation from undue disruption in the process of succession. This objective is the reason almost all OECD countries apply preferential tax treatment for family-owned businesses (Chile and Denmark are the only members which do not). The OECD report does acknowledge the benefits of reliefs and exemptions, but also warns that they can create “lock-in” effects and encourage tax planning which impacts the revenue potential of the tax.

At this stage, and from this vantage point, it is hard to say whether this arrangement is a true victory for the Lee family, or the South Korean revenue service, or both—but either way, the significance of a global-record-breaking inheritance tax bill is hard to deny.

Lessons from this Case

But what are the lessons that this case holds, and how can other countries apply them to their inheritance tax systems?

Firstly, the case provides a telling reminder of just how much scrutiny HNWIs are under when it comes to their tax affairs. The public’s moral compass sprang into action on this matter following the 2008 financial crash, when in the U.K. and elsewhere we saw celebrities and other high-profile individuals face heavy criticism for their use of tax avoidance schemes. Partly as a result of this, most HNWIs would not now countenance the use of those kinds of “off the shelf” schemes, in order to avoid damage to their profile. Indeed, such schemes have in large part been confined to the history books.

If we take that a step further, and at this moment in time, the Lee family have almost made a badge of honor out of paying their fair share of tax, to the extent that it is almost presented as philanthropic. The lesson here is that in this day and age, HNWIs do not mind paying tax, they just want to ensure they are paying the right amount, and for the system to be flexible to their particular circumstances.

Some Issues in the U.K.

In which case, if there is to be reform of the inheritance tax system to make it flexible for HNWIs, it will be important to first identify the biggest issues they are contending with, and which may cause challenges for their businesses or families. For example, in the U.K. this would likely include the following.

Rules Governing Domicile Status

An individual’s domicile status is key to determining how much of their estate is exposed to U.K. inheritance tax; however, the rules governing domicile status are not always clear or well documented. Legal support is often required wherever on the globe the individual has assets or affairs—not to mention a good knowledge of the double tax agreements between the relevant jurisdictions. For this reason, the OECD’s recommendation for greater alignment of taxing rights and adequate double taxation relief would likely be welcomed by HNWIs, at least in principle.

Rules Governing Business Property Relief

Access to Business Property Relief (BPR) is dependent on the trading profile of the business in question. Specifically, it needs to pass a 50:50 trading/non-trading activity test to qualify, which can create ambiguity and uncertainty. Some also argue this threshold is overly generous (compared to the rules governing capital gains tax (CGT) relief on the transfer of business assets, for example) and given the OECD’s recommendation that some reliefs should be scaled back, it is possible that the trading/non-trading 50:50 test could be moved to a trading/non-trading 80:20 test (bringing it in line with the CGT rules).

An alternative approach alluded to in the report would be to provide a preferential low rate of inheritance tax on business assets to facilitate succession and also to allow payment over a longer period.

BPR Rules for Alternative Investment Market Shareholdings

Shareholdings in companies listed on the Alternative Investment Market (AIM) can also be protected from inheritance tax through BPR. Consequently, many wealthy individuals are drawn to them as a tax-efficient way of passing wealth to the next generation. However, there are numerous pitfalls that must be navigated, as not all AIM-listed firms are eligible for the relief, and their eligibility can change in response to changes in the business’s activity, so continual review is necessary.

As it stands, the relief does not extend to companies which mainly or wholly invest in shares, mainly or wholly earn rental income, or those which are also traded on other recognized stock exchanges (including overseas). HM Revenue & Customs does not currently provide a list of BPR-qualifying companies—instead, eligibility to BPR is assessed retrospectively once a claim for relief is made. While the system could be made more accessible, arguably the relief was introduced to protect family business succession specifically, so in reality we may be more likely to see a narrowing of the BPR that is available on AIM shares with a renewed focus on the family business.

Rules Governing Philanthropy

The OECD report notes that positive outcomes can be influenced where charitable donations are given preferable tax treatment. For example, preferential tax reliefs can help secure and preserve assets and buildings of national and regional importance.

To some extent this is the case in the U.K., where individuals can make use of schemes such as Acceptance in Lieu of IHT and the Arts Council’s Cultural Gifts Scheme which allows for the donation of important works of art and other heritage objects into public ownership in lieu of paying inheritance tax, income tax or capital gains tax. However, the Cultural Gifts Scheme is limited by a strict annual budget, which once met, means no further donations in lieu can be made that year. It is difficult to know if or when the budget will be met, which adds an element of uncertainty for lifetime giving. These budgets could be enlarged to further encourage such donations.

Going Forward

It is common in media and political spheres for U/HNWIs to be labeled as part of the problem of inequality, but in reality, they can and should be part of the solution. Inheritance tax may also be part of that solution—how big a part depends on whether it can start providing more solutions than it does problems for wealthy individuals.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Zena Hanks is Partner in the Private Wealth team at Saffery Champness.

The author may be contacted at: zena.hanks@saffery.com

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